Just out in the Financial Times this morning. Jonathan Ford writes about a trick which allows insurance companies to conjure capital out of fresh air.
The return of Eumaeus
Actually it should be the return of Ulysses, but never mind.
We are still working on the now very comprehensive report on equity release and the valuation of the NNEG, but the blog is back in business.
Quite a few things happened in our absence, including the publication of the Smith and Jeffery report to the Irish actuaries. We will comment on that later.
Meanwhile, fresh off the press, is the transcript of this speech by David Rule. We will comment on that too, when we have worked out what is going on.
Brexit break
This was meant to have happened a few weeks ago, but we were caught up with events at Staple Inn.
Partly a Brexit inspired break, but mostly Kevin and I need to complete work on a fresh ERM paper, taking in our more recent work on calibrating the deferment rate, volatility etc., and the work of others on the same theme, such as by Radu Tunaru, and now Andrew Smith (see yesterday’s diary announcement).
It is likely we will be presenting these results at the London School of Economics, details to follow.
We will be back in mid-April, until then farewell.
The dreaded illiquidity premium
The Staple Inn event, Andrew Rendell, 1:03:14
I think where it gets more complicated is when you look at the fact that the insurers have long term liabilities – they have long term illiquid liabilities, and they are matching them with illiquid assets, so there is a synergy there when you bring those two sides together. So we just look at the Matching Adjustment concept. What’s that saying is that if you have a corporate bond, is the economic worth to the insurer the same as it is to everybody else, arguably it isn’t, and the reason for that being that a typical market participant will put a discount to the price that they would be prepared to pay for it, because that corporate bond has risks around liquidity, and it has risks around price volatility over the duration of the asset.
The insurer says ‘well I don’t care about that, because I’m going to hold my asset to maturity, and therefore I don’t need that discount, so the corporate bond is worth more to me than it is to a typical participant. So that’s what the Matching Adjustment does, that recognises that is expressed through an adjustment to the liability rather than an adjustment to the assets, but in a sense that’s what is going on.
Equity Release Mortgages: the Irish Experience
Presenters: Andrew Smith and Tony Jeffery
Event Type: CPD Event
Date:
Time: Tea/Coffee Reception: 6.00pm – 6.30pm
Meeting: 6.30pm – 8.00pm
Venue: Chartered Accountants House, 47-49 Pearse Street, Dublin 2
Description:
Equity release mortgages (ERMs), also called lifetime mortgages, have played an increasing role in generating income for retired home-owners. As new liquidity rules have reduced the supply of bank lending, so insurers have stepped in, encouraged by generous regulatory treatment for annuity writers. Some methods for valuing ERMs have proved controversial, particularly in relation to assumptions for future growth in house prices which determine whether the lender is able to recover the mortgage balance on the borrower’s death. As the volume of these assets grows on insurance balance sheets, there are concerns that insurers’ reliance on continued house price growth could make the industry less resilient to the next house market downturn.
This paper describes the basic products and illustrates alternative valuation methods with reference to Ireland and the UK. We summarise recent research and provide example calculations to illustrate the competing methods, highlighting areas of actuarial debate. We conclude with a discussion of the value of these products – both positive and negative – to society as a whole.
Regulatory self capture
Jonathan Ford, Financial Times, 17 March 2019, on the less observed phenomenon of how regulators can capture themselves through government influence or intellectual fashion.
He cites two examples. Metro Bank, which fulfilled a government need for more competition in the banking sector without costly break-ups for the high-street banks, and equity release which promised a way to address the looming pension shortfall without the state having to pick up the tab.
There was a similarly relaxed view to the rapid growth of ERMs. Firms were allowed to flog these complex products while hugely undervaluing the embedded guarantees contained within them, despite the baleful example of Equitable Life, the world’s oldest insurer, which hit the rocks in 2000 having made the same mistake. Unsurprisingly, ERMs proved highly popular with consumers and the market grew very quickly, ultimately forcing the UK’s Prudential Regulation Authority to re-examine the rules.
The problem with closing the stable door belatedly is that the horse has long bolted. Volumes of ERMs containing mispriced guarantees had already been sold. Capitalising those retrospectively is extremely difficult for the lender, and runs the risk of exposing less strongly-funded providers. Consequently the PRA chose to pull its punches.
Just out
Just Group published its 2018 results this morning. It’s all over the financial press but the headlines are
- Dividend cancelled for 2018.
- Dividends expected to recommence in 2019 financial year but at a ‘rebased level’, approximately one third of the 3.72p total dividend paid during the 2017 financial year, subject to the usual constraints.
- The firm plan to raise £300m in debt and around £80m in an equity placing. The company will issue about 94m new shares, equivalent to 10 per cent of the total already in issue.
- They report a loss of £86m for the year because of “changes to property assumptions in light of the economic and financial uncertainty caused by Brexit.” The ‘change to property assumptions’ appears to be the change referred to on p.52, where the rate of assumed future house price growth changes from 4.25% in 2017 to 3.8%.
- Deferment rate assumption drops from 0.5% to 0.3% (p.9), somewhat against the direction of travel set by PRA. The rate will have to increase to 1% by year-end 2021 (p.26)
The shares fell by nearly 15% this morning, to 84p.
Interesting that losses could be caused by house prices failing to rise by as much as forecast. As we commented yesterday, that is a bit bonkers. How much do they lose if house prices actually start falling?
Kenny on the Global Financial Crisis
Tom Kenny, chair of the Equity Release Working Party, Staple Inn 28 February 2019
… I would say what hasn’t come out of the paper is what the difference between those two approaches [i.e. Real World and Risk Neutral] is, and that’s something the working party wants to look at, to say .. what is the difference between the two approaches, and then have that policy debate, because, you know, market consistency is obviously where we are today in a large part of the financial industry, but market consistency doesn’t necessarily work. [The] global financial crisis was largely driven by the investment banks and the banking approach to modelling risk and that’s purely a market consistent approach.
May go on for longer than Brexit
ARC ERM Launch Event 28th February 2019
Craske: ” I don’t think anybody at the moment is suggesting a wholesale change in the way anybody does their modelling. We are not there yet.”
Mee: “I guess this is the first stage of the research and I think you [Tunaru] propose some interesting further work“.
Kenny: ” I would say what hasn’t come out of the paper is what the difference between those two approaches [Risk Neutral and Real World] is, and that’s something the working party wants to look at, to say .. what is the difference between the two approaches, and then have that policy debate”
Craske “the paper comes out with some relatively low volatilities that we are not used to seeing, and I think there needs to be more work done around that, around the sort of, single house price, dilapidation, old people living in there. That hasn’t really been factored in at all … this paper’s really good to get this discussion out, and I do urge you all to keep an open mind when you look at it, because we don’t always – sometimes we’ve got a very narrow way of thinking, but I do think that there’s more to go, and this may go on for longer than the Brexit discussions.”
What are they telling us?
ARC ERM launch event transcript
ARC ERM Launch Event 28th February 2019
This is a partial transcript of the presentation launching the ERM research paper at Staple Inn on 28 February 2019.